Why Isn't Our Economy and Stock Market Behaving Like the 1990s?

In the 1990s our economy and stock market grew due to the following fundamentals:

1) Productivity Expansion due to
- implementation of computing and related technologies,
- outsourcing - ie lower costs for same or even better work product
- declining (in real dollars) energy costs and increasing energy efficiency

Today, we lag behind the other developed nations in productivity growth. Our technology adoption rate has slowed, the benefit of outsourcing already realized (in fact outsourcing costs are rising due to inflation in China, India, and Mexico), and energy costs are much higher, not just for gasoline but also for natural gas.

2) Historically Low Interest Rates allowed banks and investors to realize outsized ROE's from moderate nominal returns on investment.

In November 1990 one-month LIBOR (the base index for corporate loans) stood at 9.125%, and the 10-year treasury yield was 8.39%. Through the rest of the 1990s both rates averaged roughly 1/2 those levels, allowing companies to access debt markets cheaply.

3) Massive Increases in Market Liquidity drove stock prices. In-flows came from:
- Companies switching from defined benefit retirement programs to defined contribution (eg 401k) plans.
- Increases in leveraged lending fueled by the development of the syndicated lending and the participation of non-bank lenders (ie increased demand for bank product); and
- meteoric increases in high yield bond issuance, which together with bank syndication drove a huge spike in M+A activity, which in turn drove stock valuations.

From 1990 - 1999 investment in IRAs and 401k programs tripled from $4 trillion to $12 trillion. From virtually $0 issuance in 1990, high yield bond issuance exceeded $140 billion in both 1998 and 1999, and averaged almost $100 billion per year from 1993 through 1999. Leveraged bank lending over the same period was 3x - 4x the bond issuance levels (my estimate).

The net effect on stocks? From December 1990 to December 1999 the Dow and S+P 500 grew in value over 4x (Dow 2633 to 11470, S+P from 330 to 1469). The tech heavy NASDAQ composite over the same period grew almost 11x, from 374 to 4069.

More telling, S+P PE ratios increased from roughly 12.5x in 1990 to roughly 35x in 1999. In other words, in relative terms investors were paying almost three times as much for stocks.

The bottom line: Market Liquidity Matters!

What is different now?

We talked about productivity - it has slowed and some argue that we have not had any real increase in productivity since 2000. Our energy costs are much higher. The growth of IRAs and 401Ks has slowed, and the credit markets are dead, so liquidity is down.

Rather than productivity, our economy has been dependent over the last 8 years on real estate and related industries (construction, raw materials, furnishings). As we all know, real estate has been neutered.

With no fundamental industrial growth, and no market inflows to drive stock demand, and a deflating real estate market, there is nothing in our economy to drag us out of the mire.